Options, Their Types, and How They Work

An option is a derivative contract that gives its owner the right to buy or sell securities at an agreed-upon price within a certain time period. Here's what all these terms mean:

Option: You pay for the option, or right, to make the transaction you want. You are under no obligation to do so.

Derivative: The option derives its value from that of the underlying asset. This underlying value is one of the determinants of the option's price.

Agreed-upon price: This is known as the strike price. It doesn't change over time, no matter what happens to the stock price. It has that name because you will strike when the underlying value makes you money.

Certain time period: That's the time until the agreed-upon date, known as the expiration date. That's when your option expires. You can exercise your option at the strike price at any time until the expiration date. In Europe, you can only exercise it exactly on the expiration date.

Two Major Types of Options

There are two types of options. One gives you the right to buy the asset and the other gives you the right to sell it.

Call Option

The right to buy is called a Call Option or a call. A call option is "in the money" when the strike price is below the underlying stock value. If you bought the option and sold the stock today, you'd make money.

You buy call options when they believe the security will rise in value before the exercise date. If that happens, you'll exercise the option. You'll buy the security at the strike price and then immediately sell it at the higher market price. If you feel bullish, you might also wait to see if the price goes even higher. Buyers of call options are called holders.

Your profit equals the security proceeds, minus the strike price, the premium for the call option, and any transactional fees. That's called being in the money. The profit is called the option's intrinsic value.

If the price doesn't rise above the strike price, you won't exercise the option. Your only loss is the premium. That's true even if the stock plummets to zero.

Why wouldn't you just buy the security instead? Buying a call option gives you more leverage.

If the price rises, you can make a lot more money than if you bought the security instead. Even better, you only lose a fixed amount if the price drops. As a result, you can gain a high return for a low investment.

The other advantage is that you can sell the option itself if the price rises. You've made money without ever having to pay for the security.

You would sell a call option if you believe the asset price will drop. If it drops below the strike price, you keep the premium. A seller of a call option is called the writer.

Put Option

With a Put Option, or simply a put, you purchase the right to sell your stock at the strike price anytime until the expiration day. In other words, you have purchased the option to sell it. A put option is "in the money" when the strike price is above the underlying stock value. So, if you bought the option to sell, and bought the stock today, you'd make money because your purchase price was lower than your sale price.

Six Determinants of Options Pricing

Value of the underlying asset. As it increases, the right to buy it will become more valuable. The right to sell it becomes less valuable.

Implied volatility. If traders think the price of the underlying asset will swing wildly, then options become more valuable. The increased volatility increases risk. As a result, traders demand higher returns for the options.

Dividends. If the underlying asset pays dividends, it will drive the options price up slightly. Dividends increase the values of the underlying asset.

Strike price. The lower the strike price, the more valuable the option.

Time Period. The longer the time period, the more valuable the option.

Interest rates. If interest rates are high, it will drive the options price up a bit. High interest rates depress bond prices. Bonds compete with options for investors' dollars. High interest rates make options more attractive than bonds. As a result, they can charge higher prices.

Why Trade Options?

Options give you many advantages, but they come with high risks. The biggest advantage is that you don't own the underlying asset. You can benefit from the value of the asset, but you don't have to transport or store it. That's no big deal for stocks, bonds, or currency, but it could be a challenge for commodities.

It also allows you to use leverage. You only have to pay for the cost of the option, not the entire asset. If you buy a call option, and the price rises, you've made all that profit without much investment.

You risk is much smaller if you buy a call option. You won't lose more than the premium, even if the asset's price falls to zero.

Options can protect your investments against a decline in market prices. Long-Term Equity Anticipation Securities allow you to protect against drops in stock prices for two years. Call options can also allow you to buy a stock at a lower price

You can also earn an income on assets you own. If you sell a call option, you earn income from the premiums. Your biggest risk is if the stock price rises and the buyer exercises the option. You lose the potential upside profit.

Risks

A big risk is that you are competing against hedge funds and other very sophisticated traders. They spend all day, every day, analyzing option strategies. They've hired highly educated quantitative geeks who use calculus to determine the accurate price of an option. They also have sophisticated computer models that map out all potential scenarios. These are your competitors. They are on the other side of every option trade you make.

Whatever you do, never sell a naked call option. If the asset price rises above the buyer's strike price, you are out that amount. That could total hundreds of thousands of dollars.

What Can You Trade Options On?

You can trade options on stocks, bonds, currencies, and commodities. Businesses use options to protect against volatility. Investors use options to protect against future loss. Traders and speculators try to make huge profits with little investment.

Options on stocks are the most well-known. You can buy options on or an exchange-traded fund or an index. This helps you benefit from changes in the market overall without having to research a specific company.

Currency options allow businesses to hedge against changes in exchange rates. For example, a European company could buy a currency option if it had a large payment due in U.S. dollars. If the dollar's value rose, it could exercise the option and only pay the strike price. If the dollar declines, it can let the option expire.

Firms that buy or sell commodities use options to protect against price changes. Commodities options are available for cocoa, coffee, sugar, orange juice, and cotton. Weather affects these crops, so businesses want to fix the price and reduce risk.

How to Trade Options

You must set up an account at a financial services company or work with a brokerage firm. The firm will evaluate your financial position and experience before approving you. You have to read the 188-page "Characteristics and Risks of Standardized Options."

There are three ways to buy options. First, hold them until maturity and exercise it at the strike price. You would do this if you held a call option and the price of the underlying asset rose above the strike price. Your profit would be the sales price of the asset minus the strike price, the premium, and the commission.

Second, you could trade the option before the expiration date. You'd do this if the underlying asset price rose above your strike price and you don't think it will go much higher. That happens with very volatile asset prices.

Third, you could let the option expire. You'd do this if the asset price never rose above the strike price. You would only be out the premium and commissions. Ninety percent of options expire.

The only time you would sell an option is if you already own the underlying asset. That's called a covered call. A naked call is when you don't own the asset. It's very risky.

Options typically expire on Fridays. Options have different time frames. Many options contracts are for six months. But you can also get them for a month, two months, or a quarterly.

In 2005, the Chicago Board Options Exchange created weekly options contracts. There are more than 400 types of contracts available on stocks like Apple and Facebook, indices like the Russell 2000, and exchange-traded funds like United States Oil. Hedge funds and other traders buy them to wager on short-term events. Others sell them to raise cash, collecting $500,000 each week in premiums.

As long as they are on the right side of the trade, weeklies won't affect the market. In a crisis, they could increase the volatility of a stock. The option owners might be forced to purchase millions of shares to cover their options.